"Bullish fundamentals" in dairy markets "are coming to
fruition", Commonwealth Bank of Australia said, flagging the weakened
Australian and New Zealand output prospects at a time of buoyant Chinese
demand.

The bank stopped short of making a firm forecast of an
extension to the latest market rally, saying that "the volatility in global
dairy prices over the past few years is a reminder that agricultural markets do
not move in straight lines".

Prices at GlobalDairyTrade, the auction run by New
Zealand-based Fonterra, the world's top dairy exporting company, set a 19-month
high at the last event, last week.

However, it highlighted conditions which would be expected
to support dairy values - potentially for years to come, in terms of Chinese
demand.

'Extreme moisture
deficits'

In production terms, milk deliveries from New Zealand, the
top dairy exporting country, "are at risk because of dry conditions", Mr
Mathews said, noting that the country's North Island received less than half
normal January rainfall.

"Extreme moisture deficits now exist across most key dairy
producing regions. The sharp rise in GlobalDairyTrade auction prices over the
past month, particularly for deferred deliveries, is indicative of expected
tightness in future supplies."

Poor rainfall has undermined Australian milk deliveries too,
with output down 5.5% last month on January 2012, prompting Dairy Australia to
cut to 0.2% its estimate for production growth in 2012-13.

"Difficult seasonal conditions continue to put pressure on
fodder production and feed budgets, [meaning] farmer profitability and
production has been significantly impacted in 2013," Dairy Australia said.

Growing demand

These setbacks, while in a period when northern hemisphere
producers are gearing up for their spring "flush" in milk output, comes against
a backdrop of continuing growth in demand, growing by 2.6% a year.

Trade is growing even faster, by 6%, thanks largely to the
needs of China, whose consumption of fluid milk butter and whole milk powder
has grown by 5% a year since 2010, with skim milk powder demand surging 25%.

Even so, consumption by China, adjusted to take account of
its population of 1.35bn, has a distance to go before catching up with the
regional average.

Consumption of fluid milk, per capita, is 40% of the average
for developed Asian countries, butter 16%, and cheese 12%.

'Lack of natural
endowments'

The prospect of growing demand plays into the hands of
exporters such as New Zealand, whose relative proximity to China makes it an
obvious source of dairy supplies.

"A lack of natural endowments for milk production in China, ie
a scarcity of land, fresh water, feed grain and fodder, has contributed to a
greater proportion of Chinese dairy needs being satisfied from global markets,"
Mr Mathews said.

"Despite investment in dairy genetics and infrastructure,
recent local feed shortages – evidenced by swelling imports for corn, wheat and
soybeans – support our view that future growth in Chinese dairy consumption
will be largely satisfied by imports."

Many dairy groups, including Fonterra and Danish-based Arla
Foods, have unveiled drives to tap into the Chinese dairy market.